Of Mountains And Molehills

Listening To The Hi-Fi...In the subscriber portion of our site, a while
back we penned a discussion regarding the financial stocks as being the current
canaries in the proverbial coalmine both for the US credit cycle and for the
broader financial markets. Our thought at the time was that the financial stocks
were giving us an early warning sign regarding the broad equity market as a
whole. By early April, they had turned down well below their January lows,
unlike the leading equity averages at the time, and were putting in both lower
highs and lower lows in terms of price patterns. Now that we all know what
has transpired since, we again suggest keeping a sharp eye on this sector.
At the risk of totally beating a dead horse, the financials are our way of
keeping tabs on what the macro market is pricing in at any point in time regarding
the dynamics of US credit cycle. And in our minds, the credit cycle is the key
to the big picture.

Of Mountains And Molehills...Although we believe it's very important
to monitor the charts above and the character of the greater US financial sector,
we started this discussion with a suggestion regarding the importance of monitoring
the financials really as a segue into a larger discussion regarding cash. If
indeed we are potentially at or near the crest of the greatest credit cycle
of a generation at least, just how are households positioned for perhaps having
to deal with a post-credit cycle economy? There are boatloads of charts to
follow, so get ready. Post the release of the recent Fed Flow of Funds report,
you may have seen it commented upon that households are sitting on a huge pile
of cash. We see it in Street research now and again. Often referred to as the "mountain
of money". Money just waiting to go into the market? Waiting to go into real
estate? Money that is a direct offset to household debt? Well, we thought it
appropriate to take a little closer look and perhaps compare what we see today
to historical context. Are households really sitting on top of a mountain of
money, or is it more a molehill? Well, as you'd imagine, in our eyes, and as
with so many financial relationships, it all comes back to the central question
of "compared to what?" And we suggest that the character of household cash
will ultimately be very important during the next systemic credit contraction,
which of course is ultimately inevitable. Cash being the major shock absorber
in any credit cycle downturn. We believe this question takes on heightened
importance in light of the recently enacted bankruptcy bill as well as the
OCC (Office of the Comptroller of the Currency) mandating changes in minimum
credit card payment levels.

As you know, the headline savings rate in the US has been bumping along historic
lows over the last few years. We're about as close to zero as we've ever been.
And we'll be the first to admit that there is plenty of controversy regarding
how the reported savings rate is calculated in the first place. But, one thing
that we do cling onto when looking at these savings rate numbers is the fact
that the calculation has been consistent across history. There have been no
changes in methodology. To us, it makes the numbers meaningful when set in
historical contrast. And why is cash, or savings, important? Academically,
the ability of a country to finance its build up of productive capital over
time has been through domestic businesses "borrowing" the savings of the country.
And academically, it's this productive capital that allows any country to manufacture
goods that it can "trade" in the global marketplace. Hence the whole concept
of balanced foreign trade. Now we all know full well that the US has been borrowing
the savings of its foreign neighbors, primarily Asia, for many a moon now.
It truly is one of the big "it's different this time" issues characterizing
the current environment. When we're speaking of household cash, for the most
part, we're really speaking of the accumulated savings component of
household financial assets over time. In essence, we're looking at a balance
sheet item. When the savings rate itself is calculated monthly, it's an income
statement view of life. We just wanted to make that clear before pushing ahead.

OK, so just how much cash assets are US households sitting on as of the end
of 2004? A very simplistic definition of cash includes the following: Checkable
deposits and currency, time and savings deposits, money market funds and foreign
deposits. As of 12/31/04 the number stood at just shy of $5.7 trillion. On
face value, that's one big number, right?

Before pushing ahead and looking at a number of household financial asset
relationships, we're going to be very charitable and broaden the definition
of household cash. For the sake of giving households the total benefit of the
doubt when looking at supposed liquidity and accumulated savings, let's also
include all bond fixed income holdings as a form of cash in addition to what
we showed you above. This would include household investments in Treasuries,
savings bonds, open market paper, muni and corporate bonds, agency securities,
mortgage paper and foreign bonds. We're trying to cover the waterfront here
and assume these are relatively liquid assets that could be tapped at a moments
notice, so to speak. Collectively, as of year end 2004, these household bond
asset holdings totaled $2.265 trillion. If we add these assets to the cash
assets previously described (checking, savings, MMF's, etc.), we come up with
a total of $7.95 trillion in total household cash and near cash assets for
the 4Q period end. As you can see, taken strictly on face value, it's no wonder
many a commentator has referred to this "mountain of money" as one big financial
backstop.

We'll keep the comments short and let the graphs do the bulk of the "talking".
In the following pictures of life taken as of 4Q period end, remember that
we are using the broadened definition of cash, inclusive of all household bond
asset holdings. As we mentioned, the question of cash levels "compared to what" is
what we believe to be of utmost importance when pondering an inevitable credit
cycle downturn. Let's start off with household cash relative to household common
stock holdings. As you can see below, cash as a percentage of common stocks
stands at 71%. The near sixty year average is 153%. It is clear where this
relationship stood during historic major equity market lows of the late 1940's
(prior to the bull of the 50's), the mid-70's and the early 1980's. We're currently
miles away. The all time low for the period shown was seen in late 1999 at
53%. Clearly we're much nearer historic lows than not. We sit at a level near
what was seen at the peak of the 1960's equity bull. And this is all despite
some pretty significant equity price erosion in aggregate since the first quarter
of 2000.

In terms of household cash relative to real estate holdings (at market value),
the following chart speaks for itself. We currently rest at an all time low.
It should be of little surprise at this point in the residential real estate
cycle.

Very quickly, let's put a little summation sign around what you see above.
As you know, the two most significant household assets are real estate and
common stock holdings. So what about the history of cash as a percentage of
total household assets? Look no further than the graph below.

It's perfectly clear that from the mid-1940's to the early 1950's, the ratio
fell pretty hard. We'd guess that memories of the depression were still burning
bright in the minds of many a household ten short years later in the mid-40's.
But what also stands out like a sore thumb in the above chart is the relatively
constant nature of this ratio between 1950 and 1991. Cash as a percentage of
total assets hovered between 18% and 21% for forty years. Through significant
stock market ups and downs and through a baby boom generation significantly
helping to push up the price of residential real estate in the 70's and 80's.
Along come the 1990's and cash as a portion of total household assets begins
to drop like a rock. As we have said many times in discussing many different
data points, we believe we have lived through a period of intergenerational
change regarding attitudes toward personal leverage. It's pretty darn clear
to us in the chart. For now, household cash as a percentage of total assets
is within a whisper of the lows of the last 60 years at least. As you know,
it's easy to understand why. With the Fed's reflation campaign in full swing
over the last two to three years, cash has been the lowest return asset. One
last comment. If what you see above is not a very long cycle view of life,
then we just don't know what is. In much the same way that a Kondratieff cycle
is a 60+ year affair, are we witnessing something similar above in terms of
household attitudes toward cash (inclusive of fixed income holdings)? Only
time will tell. (And we're not bringing up Kondratieff cycles to suggest that "the
end is near" so to speak, but rather to point out that some cycles are much
longer term than not. In a world of relatively continuous inflation over the
last six decades at least, cash holdings at the household level just may be
in such a cycle.) As the dollar has lost real purchasing power over time, so
have households responded appropriately and lost their taste for cash as an
asset class. Notably, the most recent plunge in this ratio started very shortly
after the Greenspan reign began.

Let's quickly turn the tables and look at cash relative to the liability side
of household balance sheets. Remember, our definition of household cash is
cash and bond holdings. As you can see, we're at a half century low
at least in the relationship displayed below that is cash as a percentage of
household liabilities. Never before have US households been so levered compared
to their cash and bond holdings. We currently rest at a level just a little
bit more than one half of the last half century average.

Although the above ratio is fine for comparative purposes. The following chart
is the data used above translated into dollars and cents. Total household cash
(cash and bonds) less the dollar amount of existing household liabilities.

As is absolutely clear, from at least the mid-1940's until 1997, households
had always carried cash balances greater than their total liabilities.
But since 1997, the level of household liabilities outstanding has shot to
the moon in terms of rate of change. Why do we say this? Because since 1997,
household cash has actually grown by $2.1 trillion. It's just that total household
debt has grown by $5 trillion. We suggest that the chart above speaks volumes
about how households have compensated for a declining stock market and a very
weak US job recovery during the current economic cycle. The coping mechanism,
so to speak, has been household balance sheet deterioration. As you already
know, the monetization of inflating residential real estate assets has played
a huge role in this phenomenon. Humble question. For how much longer can what
you see above continue? Just how much deeper does the hole between household
cash and liabilities get before households perhaps have a financial epiphany
of sorts?

The reason we suggest this question is worth some thought is that as we look
ahead to a baby boom generation who is pushing toward retirement age, cash
sure has the potential to be one of the many household assets quite in demand
to fund, or help fund, the reality of retirement living expenses. Just where
is this living expense cash going to come from now that cash as a percentage
of both household assets and liabilities is much nearer its modern historical
lows than not? We're not bringing up this question to be negative by any means,
but rather to seriously ponder the future need of household asset monetization
in some form other than increased household leverage (that's already been done
in a big way). Which asset or assets are going to be monetized at some point
to fund baby boomer retirement living expenses (that certainly are not about
to go down in terms of absolute dollar price trajectory)? Or will this ultimate
need to "acquire" cash simply take the form of reduced consumption and increased
saving sooner rather than later? Again, without sounding melodramatic, this
is a bridge that is going to have to be crossed. There's not much question
about it. With this in mind, we might ask the question, at least for the baby
boom crowd, just when does the bull market in cash begin?

A few last charts and we'll call it quits. First, we want to take a quick
look at the rhythm of directional change in household net worth and household
debt growth over the last half century. As you know, as of the end of 4Q, household
net worth stands at an all time high in absolute dollar terms. Coincidentally,
so does total household debt. But what we suggest is important is the nature
of change in these household financial characteristics. As you see in the extended
chart below, there is an approximate similarity between household debt and
net worth expressed as a percentage of GDP over time. In our minds, the acceleration
in household debt relative to GDP has been a primary catalyst for the inflation
of household asset values, primarily equity and residential real estate. Although
this is just our personal opinion, we believe a good portion of the directional
change you see below can be attributed to demographics. As you know, folks
like Harry Dent have popularized the notion that demographics drive economic
and financial trends. When we look at the charts below, we can see that in
the early 1970's household net worth as a percentage of GDP began a multi-decade
secular rise that at least for now culminated with the peaking of the equity
market. Right alongside this rise was the coincident secular rise in household
debt as a percentage of GDP. Do these charts "fit" a number of themes? Changing
household attitudes towards personal leverage. The fact that the public always
chases the inflating asset, first equities and now real estate. The real demographic
force of the baby boom generation. We believe these graphs do depict these
trends. But again, as we look ahead, we know that the baby boom generation
is going to need cash for living expenses if they expect to retire, or are
forced to retire for age/health reasons. A very simple question might be, what
happens to household asset values (implicitly net worth) if households slow
their acceleration of leverage? Will the baby boomers simply continue borrowing
until planted six feet under? The demographic rationales of folks like Dent
that theoretically explain real world economic phenomenon are implicitly crying
out this question.

Finally, one last "for fun" chart. The following is household cash as a percentage
of GDP. And what caught our eye here more than anything else was simply the
rhythm of the relationship. It sure seems obvious that relative to the benchmark
of GDP, households have repeatedly gone through cyclical periods of cash accumulation
and dissipation over time. Incredibly enough, the bottoming area in this cyclical
relationship has been quite coincidental. What this chart would suggest is
that household cash as a percentage of GDP is approaching, if not at, another
bottoming area. We'll see what happens ahead, but all the charts above tell
us that household cash relative to asset values, liabilities, etc, is quite
low from an historical point of view.

Interestingly, there have been two major periods of corporate capital spending
over the last four decades. In the 1970's corporate capital spending as a percentage
of GDP shot up like a rocket in response to the US energy crisis. Spending
on energy infrastructure was not only profitable, but vital. (By the way, will
it be so again at some point in the relatively near future? We think so.) The
second great capital spending boom we have lived through in the last half century
was the tech spending boom of the 1990's. Now, in looking at the chart above,
we can see that cash as a percentage of GDP was building quite heavily prior to
these US corporate capital spending booms. And during the spending booms themselves,
cash as a percentage of GDP fell as basically it was borrowed by the corporate
sector and spent. Where's the juice for the next US capital spending boom?
(There will be another boom, won't there?)

So when you hear it said by some Street commentator that households are sitting
on a mountain of cash at the current time, you know that the appropriate response
is "compared to what?". Again, we're not suggesting that the world is about
to go dark, but rather we're trying to paint the picture of household financial
character and potential financial flexibility as we move ahead. Looking down
the road, some type of credit cycle reconciliation will definitely rear its
ugly head. The financial stocks may be telling us that period is sooner rather
than later. In our minds, the ease of availability, ease of terms and price
of credit has been the household substitute for cash in recent years. After
all, one can "always" refi. One can "always" get a line of credit. One can "always" get
another credit card. Until the credit cycle reverses, of course. We believe
that for many folks, the distinctive lines between cash and credit have blurred.
But as with household holdings of cash and bond assets, the price, terms and
availability of credit is cyclical over time. In the current cycle, most folks
have probably long forgotten that truism. In a simple world, we'd suggest that
it will ultimately take cash at the household level to further purchase equities,
residential real estate, etc. as we move forward. And current cash levels relative
to these asset class values look much more like molehills than mountains at
the moment. But we're not in a simple world. We're in an unprecedented credit
cycle. We're in a finance based economy. Whether it's the trade deficit or
household mortgages, activity is based on borrowing, not cash. Maybe it will
only be with an ultimate change in the credit cycle that the supposed mountain
of household cash will truly be seen for what it is, not much more than a speed
bump set within the context of history. Happy motoring modern day credit aficionados.
And watch out for those potholes, OK?

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and analysts with, at minimum, 20 years of individual Street experience. Our
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